The Zuber Bottling Manufacturing Company is considering financing the construction of its new $50 million facility by selling seven-year, 10% fixed-rate,

option-free bonds at par through a private placement. The company’s investment banker has informed the company that it could also sell seven-year, 10.5%
fixed-rate bonds at par with a call option giving the Zuber Company the right to buy back the bonds at par after two years. In addition, Zuber is also informed it can sell FRNs paying the LIBOR plus 25 bp. Zuber does not believe rates will decrease over the next two years and prefers the non-callable bonds. The Zuber Company, though, can take a long or short position with its investment banker on a two-year receiver swaption on a five-year, 10%/LIBOR swap selling at a price equal to 75 bp per year for seven years.

a. Explain how the Zuber Company could create a synthetic option-free bond with the callable bond and a position on the receiver swaption.

b. What would be the effective rate Zuber would pay on its synthetic optionfree bond if rates two years later were greater than 10% and the swaption holder does not exercise and Zuber does not exercise the call option on its bonds?

c. What actions would Zuber have to take to fix its rate if rates two years later were less than 10% and the swaption holder exercises? What would be Zuber’s effective rate for the remaining five years?

d. Based on your analysis in

b. and c., what would be your financing recommendation to the Zuber Company: the synthetic option-free bond or the straight option-free bond?